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Blaming Financial Innovation for Global Financial Crisis

Category : NCFM-Equity Derivatives

March 13th 2012, Gaurav Pal-Intelivisto

FINANCIAL INNOVATION has a dreadful image these days. The 2007-09 financial crisis followed by Eurozone catastrophe and the lackluster performance of the global economy since, has led to 'great criticism' of innovation in financial domain. After all, dicey financial products and opaque mortgage-backed securities did play a dubious role in the run-up to the global crisis.

In recent decades, three particularly important sources of innovation have been financial deregulation, public policies toward credit markets, and broader technological change. At the outset, it is easy to tell why new financial products come about: they come about because people in the economy find them useful because they fulfill basic economic objectives of people in the economy.

But most of the innovations in the run-up to the crisis were not directed at enhancing the ability of the financial sector to perform its social functions. Some believe that with the complex structures of home loan securitization, financial innovation ran ahead of the capabilities of regulators. Hence - it is claimed - a better world economy requires control on innovation.

Subprime mortgage loans, credit default swaps, structured investment vehicles, and other more-recently developed financial products have become emblematic of financial crisis. Indeed, innovation, once held up as the solution, is now more often than not perceived as the problem.

Most of the critics have market-based innovation in their sights. There is an enormous amount of innovation going on in other areas, such as retail payment that has the potential to change the way people carry and spend money. But the debate focuses mainly on wholesale products and techniques, both because they are less obviously useful than retail innovations and because they were more heavily implicated in the financial crisis: think of those evil credit-defaults swaps (CDSs), collateralised-debt obligations (CDOs) and so on.

Angels or Demons

This debate revolves around a simple question: is financial innovation good or bad? But quantifying the benefits of innovation is almost impossible. And like most things, it depends. Are credit cards bad? Or mortgages? Is finance as a whole? It is true that some instruments—for example, highly leveraged ones—are inherently more dangerous than others. But even innovations that are directed to unimpeachably “good” ends often bear substantial resemblances to those that are now vilified.

It is in the nature of markets that there are some things which are indirectly socially useful but which in the short term will look to the external world like pure speculation.

Many people point to interest-rate swaps, which are used to bet on and hedge against future changes in interest rates, as an example of a huge, well-functioning and useful innovation of the modern financial era. But there are more contentious examples, too.

The credit-default swap is an even simpler risk-transfer instrument: you pay someone else an insurance premium to take on the risk that a borrower will default. These instruments offer insurance against a government default, makes many Europeans choke. There are some specific problems with these instruments, particularly when banks sell protection on their own governments: that means a bank will be hit by losses on its holdings of domestic government bonds at the same time as it has to pay out on its CDS contracts.

The much-criticized CDO, which pools and tranches income from various securities; is really just a capital structure in miniature. Risk-bearing equity tranches take the first hit when things go wrong, and more risk-averse investors are more protected from losses. The real problem with the CDOs that blew up was that they were stuffed full of subprime loans but treated by banks, ratings agencies and investors as though they were gold-plated.

As for securitization and credit-default swaps, it would be blinkered to argue they have no problems. Securitization risks giving banks an incentive to loosen their underwriting standards in the expectation that someone else will pick up the pieces. CDS protection may similarly blunt the incentives for lenders to be careful when they extend credit; and there is a specific problem with the way that the risk in these contracts can suddenly materialize in the event of a default.

But the basic ideas behind these blockbuster innovations are sound. Securitization—which worked well for decades—allows banks to free up capital, enabling them to extend more credit, and helps diversification of portfolios as banks shed concentrations of risks and investors buy exposures that suit them.

Rather than asking whether innovations are born bad, the more useful question is whether there is something that makes them likely to sour over time.

Greed is bad

There is an easy answer: people. When bubbles froth, greedy folk use innovations inappropriately—to take on exposures that they should not, to manufacture risk rather than transfer it, to add complexity in order to plump up margins rather than solve problems. But in those circumstances old-fashioned finance goes mad, too: for every securitization stuffed with subprime loans in America, there was a stinking property loan.

This argument has a lot of power. When greed takes hold, finance in all its forms is undone. Yet blaming the worst outcomes of financial innovation on human frailty is hardly helpful.

In simple terms, finance lacks an “off” button. First, the industry has a habit of experimenting ceaselessly as it seeks to build on existing techniques and products to create new ones. The economist Robert C. Merton has coined an evocative phrase ``the spiral of innovation'' to describe the dynamic tension of this process. Innovations in finance—unlike, say, a drug that has gone through a rigorous approval process before coming to market—are continually mutating. Second, there is a strong desire to standardize products so that markets can deepen, which often accelerates the rate of adoption beyond the capacity of the back office and the regulators to keep up.

As innovations become more and more successful, they start to become systemically significant. In finance, that is automatically worrying, because the consequences of any failure can ripple so widely and unpredictably. The earliest adopters of an innovation are the most knowledgeable; a widely adopted product is more likely to have lots of users with an inadequate grasp of the product’s risks. And that can be a big problem when things turn out to be less safe than expected.

The road ahead

How should policymakers ensure that consumers are protected without stifling innovation that improves product choice and expands access to sustainable credit? The first line of defense undoubtedly is a well-informed consumer. Consumers who know what questions to ask are considerably better able to find the financial products and services that are right for them.

Financial innovation has improved access to credit, reduced costs, and increased choice. We should not attempt to impose restrictions on credit providers so onerous that they prevent the development of new products and services in the future.

Though the recent experience has shown some ways in which financial innovation can misfire, regulation should not prevent innovation; rather it should ensure that innovations are sufficiently transparent and understandable to allow consumer choice to drive good market outcomes. We should be wary of complexity whose principal effect is to make the product or service more difficult to understand by its intended audience. Other questions about proposed innovations should be raised: For instance, how will the innovative product or practice perform under stressed financial conditions? What effects will the innovation have on the ability and willingness of the lender to make loans that are well underwritten and serve the needs of the borrower? These questions about innovation are relevant for safety-and-soundness supervision as well as for consumer protection.

Innovation, at its best, has been and will continue to be a tool for making financial system more efficient and more inclusive. But, as we have seen only too clearly during the past five years, innovation that is inappropriately implemented can be positively harmful.

In sum, the challenge faced by regulators is to strike the right balance: to strive for the highest standards of consumer protection without eliminating the beneficial effects of responsible innovation on consumer choice and access to credit. Goal should be a financial system in which innovation leads to higher levels of economic welfare for people and communities at all income levels.